Pension Benefits In Tiny California Town To Be Slashed As "Ponzi Scheme" Is Exposed

For the tiny little town of Loyalton, California, with a population of only 700, a failure of city council members to understand the difference between the calculation a regular everyday pension liability and a "termination liability" has left 4 residents at risk of losing their pensions from Calpers. According to the New York Times, the town of Loyalton decided to drop out of Calpers back in 2012 in order to save some money but what they got instead was a $1.6mm bill which was more than their annual budget.

For those who aren't familiar with pension accounting, we can shed some light on the issue faced by Loyalton. There are two different ways to calculate the present value of pension liabilities. One methodology applies to "solvent", fully-functioning pension funds (we call this the "Ponzi Methodology") and the other applies to pensions that are being terminated (we call this one "Reality").

Under the "Ponzi Methodology," pension funds, like Calpers, discount their future liabilities at 7.5% in order to keep the present value of their liabilities artificially low. That way, pension funds can maintain the illusion that they're solvent and the Ponzi scheme can continue on so long as there are enough assets to cover annual benefit payments.

Now, the managers of the pension funds aren't actually dumb enough to believe that the "Ponzi Methodology" accurately reflects the true present value of future liabilities because they know that, particularly in light of current Central Banking policies around the world, their actual long-term returns will be much lower than 7.5%. Therefore, they have a completely separate, special calculation that applies when towns, like Loyalton, want to exit their plan. This "termination liability", or what we refer to as "Reality", uses a discount rate closer to or even below risk-free rates which means the present value of the future liabilities is much higher.

As a quick example, lets just assume that Loyalton's 4 pensioners draw $225,000 per year, in aggregate pension benefits, and enjoy a 2% annual inflation adjustment. Assuming a 7.5% discount rate, the present value of that liability stream is about $2.9mm. However, if the discount rate drops to 2%, the present value of those liabilities surges to $4.5mm...hence the $1.6mm bill sent to the Loyalton City Council.

Of course the 4 residents of Loyalton currently drawing a pension were outraged by the discovery that their monthly benefits may be slashed.

“I worked all those years, and they did this to me,” said Patsy Jardin, 71, who kept the town’s books for 29 years, then retired in 2004 on an annual pension of about $48,000. Now, because of Loyalton’s troubles, Calpers could cut it to about $19,000.

In Loyalton, Mr. Cussins, the retiree and City Council member, said he was so frustrated about being barred from the council’s pension discussions that he and another former town worker drove to Sacramento to attend Calpers’s last board meeting.

The trustees were cordial, he said, but they held out little hope.

“We had a bunch of them come and shake our hands,” he said. “I said, ‘We need some guidance.’ They told us the city could apply to get back into Calpers next spring. But they made it very clear that they will not allow the city to get back into Calpers until that $1.6 million is paid.”

As Calpers’s chief of public affairs points out "the State of California is not responsible for a public agency’s unfunded liabilities.” And since Calpers knows that the "Ponzi Methodology" is not an accurate reflection of their true liabilities, towns like Loyalton must pay the difference between the "Ponzi Methodology" and "Reality" when they choose to withdraw.

Public pensions are supposed to be bulletproof, because cities — unlike companies — seldom go bankrupt, and states never do. Of all the states, experts say, California has the most protective pension laws and legal precedents. Once public workers join Calpers, state courts have ruled, their employers must fund their pensions for the rest of their careers, even if the cost was severely underestimated at the outset — something that has happened in California and elsewhere.

Across the country, many benefits were granted at the height of the 1990s bull market on the faulty assumption that investments would keep climbing and cover most of the cost. And that flawed premise is now hitting home in places like Loyalton.

"The State of California is not responsible for a public agency’s unfunded liabilities,” said Wayne Davis, Calpers’s chief of public affairs. Nor is Calpers willing to play Robin Hood, taking a little more from wealthy communities like Palo Alto or Malibu to help luckless Loyalton. And if it gave a break to one, other struggling communities would surely ask for the same thing, setting up a domino effect.

Mr. Davis, the Calpers spokesman, said that since 2011, Calpers had been giving its member municipalities a “hypothetical termination liability” in their annual actuarial reports, so there was little excuse for not knowing that a payment would be due upon exit. But the former Mayor of Loyalton said the paperwork was simply too confusing.

Ms. Whitley disagreed. “It’s just too confusing,” she said. “I looked at what’s been happening with all the other entities, and I saw that eventually it’s got to collapse. It’s almost like a Ponzi scheme.”

While Whitley was right that her town was trapped in a "Ponzi Scheme," she failed to recognize the critical fact that only willing participants get to participate in the Ponzi...for everyone else, we have to continue living in "Reality."